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Is the Dividend Really a Significant Source of Equity Return?

It could be, but it's not that simple

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Steven Chen
Apr 28, 2020
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It is often said that the dividend considerably contributes to the total return earned out of the stock market.

In our observation, this widely-spread belief has more or less caused a sizable portion of equity investors to hold the assumption that dividend-paying companies always generate more shareholder value. Many of them even concentrate on the income strategy.

So is the dividend the most significant source of equity return? In our opinion, this is not the case. We at Urbem believe that it is the free cash return on equity capital that plays the primary role in driving shareholder value.

Out of the free cash flow, the management can choose where to allocate the cash, which it can do through reinvesting in operations, paying off debt, acquisitions, share repurchases, paying a dividend, etc. Capital allocation can determine future results in terms of the free cash return on equity, and hence, the long-term shareholder value.

Thus, the decision to pursue a dividend payout or not is by no means the sole indicator for returns. In this regard, we would recommend focusing on the free cash flow growth instead of dividend growth.

A quick study

Let’s dive deeper into returns from dividends by conducting a quick examination regarding American large-cap stocks for the past three decades.

Between the start of 1990 and the end of 2019, the S&P 500 delivered a total return (with dividends reinvested) of nearly 1,650%. At the same time, the index went up approximately 9.25 times in terms of price – that is, a price return of 825% for the the period observed, or an annualized return of 7.7%.

In light of the 50% gap here, can we conclude that half of the S&P 500's returns came from dividends? Well, not so fast. Consider the dividend yield of the S&P 500, which ranged between 1.5% and 2% for most of the time over the last three decades. We calculated a 30-year return of around 1,000% if investors simply spent the dividends without reinvesting them into the stock market. That tells us that the dividend payout alone was far from being able to fill up the 50% gap. Instead, the discipline of reinvestment helped more with wealth creation.

Some of you may question our chosen time frame of the three-decade period. The following quotes illustrate why we chose this time period:

“An investment of $10,000 in the S&P 500 Index at its 1926 inception with all dividends reinvested would by the end of September 2007 have grown to approximately $33,100,000 (10.4% compounded). If dividends had not been reinvested, the value of that investment would have been just over $1,200,000 (6.1% compounded) – an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95% of the compound long-term return earned by the companies in the S&P 500.”

- John Bogle

"From 1871 through 2003, 97 percent of the total after-inflation accumulation from stocks came from reinvesting dividends. Only three percent came from capital gains."

- "Dividends Deliver” by Eagle Asset Management

“Investors unlucky enough to get in at the peak [before the market crash of 1929] and hang on would have had to wait about 25 years for prices to make up their losses. Following the strategy of reinvesting dividends would have shortened the wait by roughly 10 years.”

- “Yielding to the Allure of Dividends” by Value Line

None of the researchers above can emphasize the word “reinvest” enough, indicating that using your dividends to your ownership of an investment is the way to go.

We believe that investors can do even better than the passively-achieved total return by 1) reinvesting into high-return businesses only, 2) having the management reinvest the free cash flow on your behalf at the book value rather than the market price (valid only for companies that reinvest wisely), or 3) the combination of these two - think

Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.B, Financial) (BRK.A, Financial).

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway.

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